Wikinvest Wire

Confidence games and Ponzi schemes

Thursday, August 06, 2009

After hearing a lot of talk in recent days about hopeful signs for the U.S. economy and how it is vital that consumers regain their confidence in order for a recovery to truly take hold, it struck me once again that the U.S. economy, more so than most other economies around the world, is really just a "confidence game".

As in ... a hustle.

As in ... Paul Newman.

As in ... not a good long-term plan (unless, of course, you're the one running the swindle) because, at its foundation, the game is fraudulent.

From Merriam-Webster:

confidence game
noun
a scheme in which the victim is cheated out of his money after first gaining his trust
Now, this is not some short-term hustle where some guy standing on a street corner signals his partner with a tap on his nose - this is a multi-generational scam that has as much to do with flawed concepts about how economies should operate as it does with fading empires and their tendency to transition from manufacturing powerhouses to centers of finance and money shuffling where, over time, the masses are duped into borrowing and spending their way to oblivion and the government does much the same simply because it thinks it has no other choice.

That's kind of where we are now. Let me explain...

The "Engine" of U.S. Economic Growth

Last week's report on second quarter economic growth was notable for its lack of participation by consumers, the group that, heretofore, had been considered the "engine" of U.S. economic growth and, by extension, global growth.

Personal spending made a negative contribution to GDP for the fourth time in the last six quarters and policymakers and economists all across the land continued to pray for consumers to once again open up their wallets and go buy something for the greater good.

In a sign of how times really haven't changed all that much from earlier in the decade when, in 2001, Federal Reserve Governor Laurence Meyer prodded Americans to "go out and buy an SUV" to help pull the economy out of the recession, today we have the wildly popular "Cash for Clunkers" program where, after spending like drunken sailors over the last few years leading the world into the current mess, the solution to our current economic woe is to borrow and spend even more.

You see, consumption is not necessarily a bad thing. In fact, it is very necessary - people have to buy stuff. But, like most everything else, it is best done in moderation, something that hasn't exactly been a hallmark of the American consumer experience in recent years as the personal saving rate (after-tax income minus spending) went crashing from 10 percent to zero over a period of two-and-a-half decades.

IMAGE It's now rising like a phoenix and, while that may be a good (and very necessary) thing for one's personal finances, it is definitely not a good thing for the economy in the short-term.

When the local travel agent doesn't spend money at the restaurant down the street, the owners don't pay to have the place remodeled by a contractor who might have bought a new car from the auto dealer around the corner who might then have booked a vacation with the local travel agent who now eats at home.

After years of spending freely - much of it funded not by income, but by taking on record levels of new debt - consumers are now pulling back.

This makes sense.

But, what doesn't make sense is when we are told that an enduring economic rebound will require these now-thriftier Americans to "regain their confidence" in a system that has failed them so miserably over the last few years and, during a period of declining incomes and rising unemployment, go out and spend more money.

In this instance, the "victims" of the confidence game are not so much "cheated" out of their money as they are coerced to spend it when doing so works against their best interests - in a few months time, after the thrill of driving a new car has worn off, many "Cash for Clunkers" buyers will wish they could swap their monthly car payment for their old clunker.

The U.S. Government as a Confidence Game and Ponzi Scheme

Nowhere is confidence more important than at the Treasury Department and other government agencies that manage the nation's money. Come to think of it, "managing the nation's money" is probably not a good way to characterize what exactly is going on there since there is very little money to "manage" - it goes out as fast as it comes in and the process is better described as "directing the flow" of money rather than "managing" it.

Here, the U.S. government is playing a very high-stakes confidence game with its foreign creditors, many of whom must realize by now that something is seriously wrong as they grow tired of the endless cycle of American borrowing and money printing in order to make ends meet (is that still considered "making ends meet" if you have to borrow and print money to do so?).

The Chinese have been particularly vocal in this regard as they've lent us an enormous amount of money that, someday, they figure they'll want back and they'd prefer it hold onto as much of its purchasing power as possible between now and then. Whether they realize it or not, their confidence is sorely misplaced because the IOUs keep getting piled higher and, despite assurances to the contrary, there is no viable plan to reverse this process.
IMAGE Stateside, the government's finances - dominated as they are by entitlements such as Medicare and Social Security - appear to be much more of a Ponzi scheme than a confidence game, though, there are surely some characteristics of both.

Once again, from Merriam-Webster:
Ponzi Scheme
noun
an investment swindle in which some early investors are paid off with money put up by later ones in order to encourage more and bigger risks
Let's face it, when you and your employer each have 6.2 percent of your wages sent directly to Uncle Sam and deposited into the social security "trust fund", you are "investing" this money in the biggest Ponzi ever perpetrated because your money goes directly back out to recipients and, to make things even worse, what's left over is spent by the government.

Though it didn't start out that way - when the plan was conceived, the average life expectancy was right about the same age that recipients could start collecting payments - the fact that there have been no substantive reforms to make this program into a sustainable system leaves it in a current condition that would make Charles Ponzi green with envy.

If not for our current fiat money / fractional reserve banking system, where there are virtually no limits on the amount of money and credit that can be created "out of thin air", this confidence game/Ponzi scheme run by the U.S. government would have ended long ago.

The Nirvana of Rising Asset Prices

But the biggest deception currently being carried out that directly affects the American public and, for that matter, billions of people around the world in our new globalized economy, has to do with asset prices and, here too, there are characteristics of both a confidence game and a Ponzi scheme.

Centuries ago, equity markets began playing a vital role in building industries and fostering commerce. In return for a "share" of the company's future income stream, mostly in the form of dividends, investors would pay the going rate for a "share" in the company, taking on the added risk of the value of that share fluctuating in price, soaring or sinking as companies prospered or faltered.

In recent years, however, fewer and fewer companies have paid substantial dividends and "investors" have been trained to seek "capital appreciation" instead. That is, when some new investor pays more than they did for the same share, making their share worth more.

Property markets have made a similar transition.

It used to be that real estate was just another depreciating asset, oftentimes requiring very expensive maintenance, and, under a best case scenario, home values wouldn't rise much faster than prices in general.

But here too, over the last few decades, a staid asset class was transformed into a superstar investment sector as money and credit flowed freely from the U.S. government and its banking system, luring millions of "investors" looking to make big "capital gains".

The housing bubble that burst back in 2006 was a near perfect Ponzi scheme that came to an abrupt halt after the last of the new buyers could be found - subprime buyers provided that last push for the late-great U.S. housing bubble.

In both stocks and housing, it was rising asset prices that maintained confidence and attracted new money as prices rose. Of course, as we've come to learn, asset prices don't always go up.
IMAGE In fact, that peak you see above in 2007 may represent a generational high in asset prices since so much of this increase was fueled by a massive expansion of credit enabled by lax lending practices that have now unraveled over just the last couple years.

It was a credit expansion of monumental proportions that pushed asset prices as far as they could be pushed and then things just kind of fell apart.

But, sadly, this won't stop policymakers from trying to push asset prices back up again. To see a shining example of just how effective this can be, one has only to look at China today to see what wonders a few hundred billion dollars in new credit can work on a slumping stock market and real estate market.

The entire world has been duped into believing that asset prices can continue to rise indefinitely and that we'll all eventually grow wealthy as a result. Even in the aftermath of last year's financial market melt-down most still believe that if only governments around the world create enough new money and credit, drawing in many more confident new buyers, the lofty asset prices seen in recent years will be restored.

Ultimately, they will be disappointed.

Confidence games and Ponzi schemes never end well and they are certainly no way to run the world's largest economy.

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15 comments:

Anonymous said...

Speaking of confidence games, what about this?

Washington, D.C., Aug. 4, 2009 — The Securities and Exchange Commission today filed civil fraud and other charges against General Electric Company (GE), alleging that it misled investors by reporting materially false and misleading results in its financial statements.
Additional Materials

* Litigation Release No. 21166
* SEC Complaint

The SEC alleges that GE used improper accounting methods to increase its reported earnings or revenues and avoid reporting negative financial results. GE has agreed to pay a $50 million penalty to settle the SEC's charges.

"GE bent the accounting rules beyond the breaking point," said Robert Khuzami, Director of the SEC's Division of Enforcement. "Overly aggressive accounting can distort a company's true financial condition and mislead investors."

David P. Bergers, Director of the SEC's Boston Regional Office, added, "Every accounting decision at a company should be driven by a desire to get it right, not to achieve a particular business objective. GE misapplied the accounting rules to cast its financial results in a better light."

Anonymous said...

The psychology of mass bubbles is fascinating. Some argue (I am neutral) that the victims of mass cons are often willing and knowing participants in an elaborate escape episode. The uglier the reality, the greater the need for an alternative. There are strong parallels with drug-seeking behavior (including gambling).

Nice synopsis, Tim. A while back, I think you still believed in the need for central banking. I'm wondering if that still holds.

--

In the Land of Mordor where the Shadows lie.
One Ring to rule them all, One Ring to find them,
One Ring to bring them all and in the darkness bind them

Anonymous said...

@anon1,

That's great. $50M is like a paying parking ticket for armed robbery. This is a criminal offense. And guess who pays it? The shareholders not the execs that benefitted.

Greyhair said...

Tim, I think your analysis is right .... and wrong. It's right in a pontificating sort of way and looking through a telescope into the future. It's wrong in terms of a current investment analysis. The opportunity cost lost by mixing up the two views is enormous.

But who knows when the long view becomes current reality? That's the million dollar question isn't it? I don't think it's likely to be now or soon as long as American's retain the economic (and particularly) the military dominance in the world. And when the cataclysm comes, I suspect it will come in drips not torrents.

Anonymous said...

The US savings rate went to zero mostly because the US central bank tried to compensate for too much overseas savings by forcing Americans to save nothing at all. This was a terrible policy that has put the US deeply into debt. Excessive private debt to GDP was a prime cause the Great Depression. Private debt did not go down until WWII forced Americans to save (pay down their debt). Low private debt to GDP after WWII allowed the economy to prosper once again.

That is, until the central bank drove private debt to GDP to unstable levels once again with its misguided policy. The central bank should be abolished, as it is completely incompetent. Eliminate inflation, and let the free market set interest rates.

harry shutt said...

Tim,

Your analysis is spot on but for one big error: your likening Social Security to a Ponzi scheme.

What Ponzi and Madoff did was to take in money on the pretense they were going to invest it. The deal with SocSec is that today's workers pay for yesterday's workers (now retirees) on the firm understanding they will receive the same in their turn on retirement (no scam). If you posit there may not be enough budgetary funds in future to finance this you have to accept the same is true of any other component of the US current budget, including (e.g.) judges' and congressmen's salaries. Is that a Ponzi scheme?

Harry Shutt

Anonymous said...

^^Harry has never read an AARP bulletin. The Elder lobby, along with their Congressional enablers, firmly assert that SS payments are a return on the recipients' contributions. The last thing the AARP will ever admit is that the SS is just another form of welfare. The continuation of the SS con requires that current payers, particularly 20-somethings, never learn that it is highly unlikely that they'll ever see the money they're paying in now ever paid out to them in the form of benefits.

Anonymous said...

@anon208,

Is there such a thing as too much savings? Savings is the difference between what you produce and what you consume. I suppose socialists would argue that those without surplus production are entitled to be supported by those with. This of course eventually leads to very little or no surplus at all anywhere.

Pool Shark said...

It's even worse than you think Tim.

Remember the device used in the denouement of "The Sting" to relieve Lonnigan of his money? It was called "The Wire." Results of horse races were held up just long enough to tip the gambler so that he could bet on a sure 'winner.'

GS is currently running "The Wire" on our equities markets with so-called "Flash Trades." In essence, they get to see who the winner is before they place their own HFT bets.

Government finance, commodities speculation, equities markets... the whole damned casino is rigged!

getyourselfconnected said...

This may be the best "putting it all together" article I have read ever. I have featured it tonight and I hope it finds a big audience.

Anonymous said...

I like Pool Shark's observation. I did not quite remember the "wire" gimmick from "The Sting". But, GS's flash trades are nothing but that gimmick.

I was thinking of only a few ways they can make so much money on trading

(1) insider information
(2) really great algorithms (software) that they claim.
(3) heavy leverage with significant risk
(4) getting monopoly money from fed reserve and using it for trading (gambling)

and combination of all.

But, no matter how sophisticated the algorithms are, they cannot beat the market every single time. Also, that means they are taking too much risk (leverage) - which is the kind of behavior that fed reserve & treasury should not be encouraging in the first place in this environment. The chances that they go would go wrong would be very high, and the whole system would implode again.

When I think about this citibank guy making billion dollar profits to claim $100m bonus, I smell a rat there too. what they are doing should be illegal. Oil cartel is called cartel because they are trying to influence the market which is against free trade principles. Unfortunately, you cannot discipline them easily because we are talking about countries. But, in the old days (and even now), the traders make obscene windfall profits by price gouging or restricting or holding back supply intentionally. I remember hearing about this during last year's oil spike, and people complaining about gas station operators doing this. I don't understand why commodity traders actions are not illegal just like any other trader if they amount to profiteering like this.

When slowly people start realizing this, they do not participate in the confidence game. I agree with the sentiment - the whole damned casion is rigged.

Tailwind said...

Tim:
Nice piece summarizing where we stand and even better analogy to the Sting by Pool Shark. The thing that disappoints and infuriates me in equal portions is our government---the one formed by a Constitution that I swore to uphold---is blatantly and criminally (IMHO) hosing its citizens by first, urging people to continue going into debt and second, enslaving the nation with even more spending for questionable programs, entitlements and pork.

While people have bought into the Bezzle for more than 30 years, they appear to have now awakened and are becoming more and more aware of the damage done to themselves and the nation. Our so called political elites, however, have decided that they 'know best' and are trying their best to maintain power by sacrificing the citizens at the alter of Debt.

Disgraceful & disgusting does not begin to cover what the pols, the media and Wall Street Banksters are doing and I am sick of the BS. If we don't rise up and put and end to this soon, IT will end US.

Anonymous said...

GS and the big investment banks make most of their gains by offloading their losses onto the public. The CDS contracts they held with AIG should have been wiped out. Instead AIG was bailed out so they could get paid.

Anon820pm, If someone makes a risky bet and nets $100M, they should get it. But, if they lose it, then the public should not have to bail them out.

This is the true essence of central banking and fractional reserve lending. It allows favored banks to lever up on big bets risk-free. Well not quite, there is the risk that the public figures it out and refuses to absorb the losses.

Anonymous said...

Anon901pm said if someone makes a risky bet, and nets $100M, they should get it. But, if they lose it, then the public should not have to bail them out.

I would agree in general, but, I several problems with the approach.

1.Just think for a moment- the reason why we should not allow this kind of speculation and regulate it - is because it brings down the whole company, and is a systemic risk.
2. The argument by democrats (to save this) has been that it would bring down the economy, and they never then try to rein in executive compensation - even though they make too much noise about it. Even Geithner made the same argument to a NYT reporters that we did it for us (overall health of the economy), and not for wall street bankers. And, that is the excuse they throw at us. On the other hands republicans are willing to let the companies go down (creative destruction), but, then we don't know how the broader economy suffers in the process.
3. and remember that the guys who made boatloads of money don't have to worry if the economy goes down. This guy who is asking for $100M - it is not like he owns Citibank, and has great attachment. Most of the time problem with executive compensation is. Even at the risk of oversimplication on exec compensation, most of these guys make so much short money in millions that their generations do not have to work. So, at that point it is just their reputation we are talking about. In 1789 Paris, they would have been lynched by a mob.
4. Do not forget that now onwards the speculation will be using monopoly money from the Fed, and we just have to believe that Fed is monitoring them closely and regulating them:-)as if they did a marvelous job in last 20 years that we want to entrust them with even more reponsibility. That is the reason I like Ron Paul, but, he sometimes seems too extreme.
5. I suspect the tactics he used to make that money is suspicious of holding back Oil supplies on the high seas until prices shoot, and dumping it later. that is classic price gouging no matter how you look at it. And, what I am afraid is that it was similar behavior that was displayed by Enron energy traders. And, just like other banks got on the party that GS started, and then everyone started taking outsized risks. It could happen again with other banks copying the same behavior.

well, if you are a saver, good luck, you are not going to make any money, you are giving your money interest free to banks for their speculation.

Anonymous said...

Anon1031,

I don't know the exact circumstances that led to the $100M bonus in question. My point is if someone risks their own property and fairly nets a gain, I believe they should have the right to keep it no matter how obscene the amount. Further regulation by a government body is not the answer. Effectively, you would be still be empowering a collective, or worse an elite, to distribute rights to individual property.

The answer is not a further concentration of power. I like Ron Paul too and do not find him extreme at all. The 'system' will regulate itself if you return enough property rights back to individuals. This would be as simple as repealing legal tender laws; which would have the effect of greatly weakening the central bank and government.

I am a good saver and the money is not going to banks. But they don't need me anyway. The Fed exists to support their activities and is now asking for more power while trying to avoid letting us know what they are doing with our money.

People, take the time to try understanding what those like Ron Paul are trying to do. He is an advocate of weakening government and taking back control of our lives.

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